In the first part of our blog on mezzanine loans, we explained the advantages and uses of mezzanine loans. In this follow-up, we will explain how these unique type of subordinate loans are structured in a way that benefits both lender and borrower.

Mezzanine loans are usually sought out by smaller companies or holding companies and can be completed through a flexible structure which has been set up to serve the specific requirements and objectives of the borrowing company as well as the lender. The majority of mezzanine loans utilize subordinated notes and preferred stock in order to achieve a certain rate of return, usually between 14% and 20%. The lender will generally work with the borrower to determine a security structure which will meet the necessary return without burdening them with the full cost of the loan. This is achieved by combining the following:

• Cash Interest – a periodic payment of cash against the outstanding balance of the loan that can be based on either a fixed or variable rate, similar to the interest charged on the superior loan.
• PIK (Payable In Kind) Interest – a periodic payment which is made by increasing the principal amount owed rather than through a cash transaction (for example, a $100,000 loan with a 10% PIK interest rate would have a balance of $110,000 at the end of the period with no cash payout).
• Ownership – an equity stake in the borrower’s company in the form of either attached warrants or convertible feature allowing the lender to claim shares of the company if the loan is not repaid on time and in full.

The addition of PIK interest and ownership options allows the lender to realize a high ROI (return on investment) while deferring the borrower’s repayment of the entirety of if until the due date for the loan’s repayment arrives or ownership of the company changes hands. This deferred compensation decreases the financial burden of the borrower allowing them to make more of the borrowed funds. Full disclosure:  Montegra Capital only funds first position types of loans and does not fund mezzanine loans.

This blog was written by Bob Amter, President of Montegra Capital Resources, LTD., a Colorado hard money lender.  [google_authorship] has been in the private capital lending business for 41 consecutive years.